Jihoon Lee Northeastern University

Jihoon Lee Northeastern University
for the individual choice for the choice interaction for the economy-wide interaction
Individual choice: the decision by an individual of what to do, or what not to do Basic principles
Resources are scarce The real cost of something is what you must give up to get it How much? is a decision at the margin People usually take advantage of incentives
Basic Concepts of Economics
A resource is anything that can be used to produce something else

Ex.: land, labor, capital
Resources are scarce: unlimited needs with limited resources

Ex.: fossil fuels, lumber, (clean) water/air, intelligence
The real cost of an item is its opportunity cost: what you must give up in order to get it Opportunity cost is crucial to understanding individual choice
Ex.: The cost of attending the economics classSleep? Coffee at Starbucks with friends? Work? I would rather be are referring to the opportunity cost
Its all about what you have to forgo, but remember its the forgone value of the best alternative activity only, not the sum of all
Basic Concepts of Economics 5
Trade-off b/w costs and benefits of doing something Marginal benefit-cost analysis: making tradeoff at the margin
comparing the costs and benefits of doing a little bit more of an activity vs. doing a little bit less Ex.: Eating one more slice of pizza, studying one more hour, sleeping one more hour, hiring one more worker, etc.
An incentive is anything that offers rewards to people who change their behavior
Ex.1: wage increase more people want to work Ex.2: price of gasoline increase more people demand fuel-efficient vehicles
People respond to these incentives (or, disincentives)
Interaction of choices: my choices affect your choices, and vice versa Basic principles
There are gains from trade Markets move toward equilibrium Efficient usage of resources is a good thing for the society Markets usually lead to efficiency When markets fail, government intervention can improve social welfare Basic Concepts of
Economics
Trade in a market economy: provide goods and services to others and receive other g/s in return Gains from trade: get more of what they want through trade than they could under self-sufficiency
Due to specialization
Each person specializes in the task that he or she is good at performing The economy, as a whole, can produce and consume more
I hunt and she gathers otherwise we couldnt make ends meet.

The New Yorker Collection 1991 Ed Frascino from cartoonbank.com.
Equilibrium in an economic sense is a situation when no individual would be better off doing something different
Any time there is a change, the economy will move to a new equilibrium
Ex.: What will happen to the price of gas when oil producing countries decide to produce more barrels of oil per day?
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An economy is efficient if all opportunities are taken to make some people better off w/o making other people worse off Then, is economic efficiency always the best policy goal? issue of efficiency vs. equity
Equity: everyone gets his/her fair shareWhat is fair? Ex.: Handicapped-designated parking spaces in a busy parking lot Equity side: making life fairer for the handicapped people Efficiency side: letting several parking spaces left unused How far should we go?
The incentives built into a market economy help resources be used efficiently
Prices are set where buyers and sellers agree with No opportunities are left unexploited
Exceptions: market failure

The individual pursuit of self-interest in the markets can make society worse off The market outcome is inefficient
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Negative externalities: when producers (sellers) shift costs to others

Pollution, for example, is a by-product of manufacture Total cost = sellers production cost + pollution cost When pollution costs are shifted, supply is greater than socially optimal, and so is the pollution
Positive externalities: when consumers (buyers) may create benefits for others
Vaccinations, for example, can prevent neighbors from getting flue Total benefit = individual benefit + benefits to others When more people want to enjoy free ride, the aggregate demand for vaccinations is less than socially optimal
The market outcome is socially optimal (socially efficient) only when

The sellers pay the full costs of production, and The buyers capture the full benefits of g/s
Government can help the market achieve the socially efficient level of outcome with regulations, taxes, and fines (for negative externalities) or subsidies (for positive externalities)
More discussion in detail are coming in later chapters!
14
Basic Principles
One persons spending is another persons income If you spend less at a grocery store, the store employees may either lose their jobs, or take pay cuts Overall spending may exceed or fall below the economys production capacity (or potential output) If spending exceeds potential output, inflation is likely If spending falls below potential output, economic recession and increase in unemployment are likely Government policies can change spending Monetary/fiscal policies
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Comparative Advantage using Production Possibility Frontier Circular-Flow Diagram
A model is a simplified representation of realities that is used to better understand real-life situations
Ex.: a model showing how much income people spend for purchasing g/s; C = + Y
Other things equal

This assumption means that all other relevant factors remain unchanged for simplicity
17
The production possibility frontier (PPF)

It illustrates the trade-offs facing an economy that produces only two goods. It shows the maximum quantity of one good that can be produced for any given production of the other.
18
Quantity of coconuts 30 Feasible and efficient in production D Not feasible
A 15 Feasible but not efficient B C
Production possibility frontier (PPF)

0
20
28
40
Quantity of fish
19
Quantity of coconuts Producing the first 20 fish . . . 35 30 A 25
requires giving up 5 coconuts But producing 20 more fish . . .
20
15 10 5 requires giving up 25 more coconuts
PPF 0
10
20
30
40
50
Quantity of fish
20
Quantity of coconuts 35 E 30 A 25 20 15
Production is initially at point A (20 fish and 25 coconuts), it can move to point E (25 fish and 30 coconuts) due to economic growth
10
5 Original PPF 10 20 25 30 40 50
New PPF Quantity of fish

21
0
Quantity of coconuts
(a) Toms Production Possibilities
30
Toms consumption without trade
9 Toms PPF 0
28
40
Quantity of fish
22
(a) Hanks Production Possibilities Quantity of coconuts
20 Hanks consumption without trade
8 Hanks PPF 0 6 10 Quantity of fish

23
Toms OC One fish One coconut 3/4 coconuts 4/3 fish
Hanks OC 2 coconuts 1/2 fish
Both Tom and Hank are better off when they each specialize in what they are good at and trade Tom is good at fish: Toms OCf < Hanks OCf
Tom has comparative advantage in and specializes in catching fish
Hank is good at coconuts: Toms OCc > hanks OCc of Basic Concepts
Economics
Hank has comparative advantage in and specializes in
24
(a) Toms Production and Consumption Quantity of coconuts
(b) Hanks Production and Consumption Quantity of coconuts
30
Toms consumption without trade Toms consumption with trade
Hanks production with trade 20 Hanks consumption with trade Hanks consumption without trade Hank's PPF 0 6 10 Quantity of fish
25
10 9
Toms production with trade Toms PPF
10 8
0
2830
40 Quantity of fish
Comparative Advantage
Lower opportunity cost to perform a task than the other person
Absolute advantage
Lower production cost (or, higher productivity) to perform a task than the other person
Comparative advantage matters!

Tom has absolute advantage in both activities, but still specialize in fishwhy? Because Tom gains benefits by doing so! (1more coconut & 2 more fish) Hank also benefits by specializing in coconuts (2 more coco & 4 more fish) Basic Concepts of 26 Mutual benefits from following comparative advantage! Economics
(a) The U.S. Production Possibilities Frontier
(b) Canadian Production Possibilities Frontier
Quantity of aircraft
Quantity of aircraft
3,000 U.S. consumption without trade
Canadian production with trade
U.S. consumption with trade

1,500 1,000 U.S. production with trade U.S. PPF 0 1 2 3
Quantity of pork (millions of tons) Basic Concepts of Economics
2,000 1,500
Canadian consumption without trade
Canadian consumption with trade Canadian PPF 0 0.5 1 1.5

Quantity of pork (millions of tons) 27
U.S. PPF is relatively flat

It implies that U.S. has a comparative advantage in pork production U.S. specializes In pork production and trade
Canadian PPF is relative steep

It implies that Canada has a comparative advantage in aircraft production Canada specializes in aircraft production trade
Both countries gain from specialization and trade: both enjoy more benefits than if they were self-sufficient
Money
Households
Money
Goods and services
Factors
Factor Markets
Goods and services
Factors
Money
Firms
Money
29
Factor markets: determine income distribution among factor owners wages, interests, rent Real-world complications
International trade Transactions b/w firms Government Financial markets
30
Description, and prediction: positive economics

Its about facts, and describes how the economy actually works Ex.: the average price of gas in May 2008 was higher than in May 2007
Prescription: normative economics

Its about values, and prescribes how the economy should work Ex.: Gas prices are too high
A solution to normative economics

Ex.: If policy option A is more efficient that B for achieving the same goal, then A is better than B
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Opportunity Cost Marginal Analysis
Its the sum of explicit cost and implicit cost

Explicit cost: actual outlay of money Implicit cost: forgone value of best alternative activity Ex.: OC of an additional year of school
33
Accounting profit: businesss revenue minus explicit costs and depreciation Economic profit: businesss revenue minus OC of its resources Ex.: Profits at Babettes Cafe
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Relevant to how much decisions

Ex.: how many slices of pizza want to eat, how many workers want to hire
Its an analysis at the edge, comparing additional benefit to additional cost of one more unit of consumption (or production) Marginal benefit: the additional benefit earned by consuming (producing) one more unit of g/s Marginal cost: the additional cost incurred by consuming (producing) one more unit of g/s
36
Marginal benefit (per wing)
Marginal benefit curve, MB
0
6 7 Quantity of chicken wings

37
Marginal cost (per wing)
$4.00
3.00
2.00 Marginal cost curve, MC
1.00
Quantity of chicken wings

Its the quantity that generates the maximum possible total net gain And the total net gain is maximized when MB is equal to MC
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MB, MC (per wing)
Quantity of chicken wings 0 1
Net gain
(per wing)
Total net gain

(profit per serving)
$4.00
2 3 4 5 6 7
$3.50 1.70 0.70 0.40 0.10 0.10 0.20
$0 3.50 5.20 5.90 6.30 6.40 6.30 6.10
3.00
2.00
Optimal point 1.00 MC
MB
0 1 2 3 4 5 6 7 Quantity of chicken wings
Optimal quantity
Sunk cost: a cost that has already been incurred and non-recoverable Ex.: You went to Sushi Buffet How many dishes you want to have? Worth more than (or at least as much as) what you paid? Or, lets say, according to your marginal analysis?
Sunk cost should be ignored in decisions about future actions

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What is $x realized t years in the future worth today?

It must satisfy this formula:
$V (1+r)t = $x, or $x $V = (1+r)t

where $V is the present value of $x realized t years in the future at r, the annual interest rate Ex.: If x = 1, r = 0.1, and t = 2, then V =
1 1+0.1
0.83
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NPV of a project is the present value of current and future benefits minus the present value of current and future costs
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What are Free Trade Agreements (FTAs) and the World Trade Organization(WTO) Agreement? Explain the relationships between the two. How many FTAs with how many countries does the U.S. have in force? With which countries does the U.S. has recently signed the FTAs? Discuss the possible pros and/or cons of having FTAs.
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A resource is anything that can be used to produce something else

Resources are scarce: unlimited needs with limited resources

Basic Concepts of Economics

People respond to these incentives (or, disincentives)

Basic Concepts of Economics

I hunt and she gathers otherwise we couldnt make ends meet.

Basic Concepts of Economics

Basic Concepts of Economics

Exceptions: market failure

Negative externalities: when producers (sellers) shift costs to others

The market outcome is socially optimal (socially efficient) only when

Basic Concepts of Economics

Basic Concepts of Economics

Comparative Advantage using Production Possibility Frontier Circular-Flow Diagram

Other things equal

Basic Concepts of Economics

The production possibility frontier (PPF)

Basic Concepts of Economics

Quantity of coconuts 30 Feasible and efficient in production D Not feasible

A 15 Feasible but not efficient B C

Production possibility frontier (PPF)

Quantity of coconuts Producing the first 20 fish . . . 35 30 A 25

requires giving up 5 coconuts But producing 20 more fish . . .

New PPF Quantity of fish

(a) Toms Production Possibilities

Toms consumption without trade

(a) Hanks Production Possibilities Quantity of coconuts

20 Hanks consumption without trade

8 Hanks PPF 0 6 10 Quantity of fish

Basic Concepts of Economics

Toms OC One fish One coconut 3/4 coconuts 4/3 fish

Hanks OC 2 coconuts 1/2 fish

Hank has comparative advantage in and specializes in

(a) Toms Production and Consumption Quantity of coconuts

(b) Hanks Production and Consumption Quantity of coconuts

Toms consumption without trade Toms consumption with trade

Toms production with trade Toms PPF

Comparative advantage matters!

(a) The U.S. Production Possibilities Frontier

(b) Canadian Production Possibilities Frontier

3,000 U.S. consumption without trade

Canadian production with trade

U.S. consumption with trade

Canadian consumption without trade

Canadian consumption with trade Canadian PPF 0 0.5 1 1.5

U.S. PPF is relatively flat

Canadian PPF is relative steep

Goods and services

Goods and services

Basic Concepts of Economics

Description, and prediction: positive economics

Prescription: normative economics

A solution to normative economics

Basic Concepts of Economics

Opportunity Cost Marginal Analysis

Its the sum of explicit cost and implicit cost

Basic Concepts of Economics

Basic Concepts of Economics

Relevant to how much decisions

Basic Concepts of Economics

Marginal benefit (per wing)

Marginal benefit curve, MB